Finance Concepts

What is FCF? How do you calculate it?

Nitin GargLeave a comment

Free Cash Flow (FCF) is the cash flow generated by the core operations of the company after deducting the investments in new capital. Mathematically,

FCF = NOPLAT – Net Investment

Where,

NOPLAT = Net Operating Profit Less Adjusted Tax, represents the profits generated by the core operations, minus the taxes. It excludes non-operating income and interest expense.

Net Investment = Increase in the invested capital from Year 1 to Year 2. Net Investment in non-operating assets, and gains/losses/income related to these non-operating assets are not considered.

Calculating FCF

FCF = NOPLAT + Non-cash Operating Expenses – Investments in Invested Capital

Where,

Non-cash Operating Expenses are those expenses that are deducted from the revenue to generate NOPLAT. Depreciation and non-cash employee compensation are two most common ones. We do not add back the amortization and impairment of intangibles to NOPLAT.

Investments in Invested Capital: To grow the business, companies consistently invest a portion of the gross cash flow back into the business. Four categories form gross investment:

  • Operating Working Capital: Investments primarily in operating cash and inventory. Non-operating assets (excess cash) and financing (dividends payable, short-term debt) are excluded from Operation working capital.
  • Net Capital Expenditures equals investment in Property, Plant and Equipment (PP&E), minus the book value of any sold PP&E. It is determined by adding the increase in net PP&E to depreciation. Do not estimate the capital expenditures by the change in the gross PP&E since it can understate the actual amount.
  • Include investment in capitalized in the gross investment.,
  • Goodwill and acquired intangibles: For acquired ones, where cumulative amortization has been added back, we can calculate the investment by the change in the net goodwill and intangibles. For intangibles that are been amortized, add the increase in net intangible to amortization.

What is WACC? How do you calculate it?

Nitin GargLeave a comment

While valuing an organization using Discounted Cash Flow (DCF), forecasted Free Cash Flow (FCF) is discounted by the Weighted Average Cost of Capital (WACC). WACC represents the opportunity cost of capital for investors when they allocate their funds towards a business.

WACC can be calculated using the following formula:

WACC = D/V x Kd (1 – T) + E/V x Ke

Where,

D/V = Debt to Enterprise Value (EV) based on market value

E/V = Equity to EV based on market value

Kd = Cost of debt

Ke = Cost of equity

T = Company’s tax rate

None of the above components are readily available. Hence, we use various models, assumptions and approximations to arrive at each of the values. There are 3 important factors that need further attention.

  • Cost of equity is depended on (1) Risk-free rate (2) Market risk premium and (3) Beta. We employ CAPM to estimate the cost of equity.
  • After-tax cost of debt depends on (1) Risk-free rate (2) Default spread and (3) Marginal tax rate. For an investment grade company, we employ yield to maturity (YTM) on its long-term debt, and for a public company, we use YTM on bonds’ cash flows and price.
  • Capital Structure (proportion of debt and equity to the EV). The target capital structure is derived by the company’s current debt-to-value ratio. We always use the market values (and not the book values).

Couple of points noteworthy:

  1. WACC based models works well when a company maintains a relatively stable debt-to-value ratio. But for a LBO, it can understate or overstate the impact of the tax shield. In such a situation, we should discount the FCF at unlevered cost of equity and value tax shields separately.
  2. If a company’s debt-to-value ratio changes, we use Adjusted Present Value (APV).

Let’s take an example. Consider a startup wants to raise a capital of $1 million so that it can buy office space and equipments needed to run its business. The company issues 6,000 shares at $100 each to raise $600,000. The shareholders expect a return of 10% on their investment. So, the cost of equity is 10%.

The company then issues 400 bonds of $1,000 each to raise $400,000. The bondholders expect a return of 8%. So, the cost of debt is 8%.

Now, the startup’s total market value ($600,000 equity + $400,000 debt) = $1 million. Let’s assume its tax rate is 35%. So, the company’s WACC is 6%

(($600,000/$1,000,000) x 0.1) + [(($400,000/$1,000,000) x .08) x (1 – 0.35))] = 0.0598 ~6%

This means that for every $1 the start-up raises from its investors, it must return $0.06 to them.

You may also want to read about Enterprise Value here.

Valuation: Asset Approach, Income Approach and Market Approach

Nitin GargLeave a comment

ValueThere are three approaches to valuing a business. I’ll discuss them in detail.

1. Asset Approach

Asset approach looks at a business from a set of assets and liabilities of the company for business valuation. It’s based on the economic principle of substitution and tries to answer the question:

What would cost me to recreate a similar business that generates the same economic benefits for its owners?

Every operating business holds assets and liabilities. So, valuing these assets and liabilities and taking the difference between the two values would give us the value of the company. While it sounds simple, valuing a business can be a daunting task since most of the components do not find a place in the balance sheet. Internally developed products (unless patented) are such an example. But the market value of these assets can be far greater than the combined value of all the assets that resides in the financial statement.

Few points noteworthy

  • An asset-based valuation approach is usually adopted when a business has a very low or negative value as an ongoing business. Consider the case of an airline company that has few routes, high labor and operating costs, and is losing money every year. Using the other valuation methodologies, one can derive a negative valuation for the company. But to its competitors, the assets (routes, landing rights, leases, equipment and airplanes) can have a significant value. In this case, this approach will value the company’s assets separately and will set them aside from the money losing business. The asset-based valuation approach will typically yield the lowest valuation of the 3 approaches for a profitable company, but it may result in an appropriate value depending on the situation.
  • Asset approach may be used in conjunction with the other valuation methods. For example, let’s consider a retail business which has only one location. It owns the property and the building in which the business operates. If the company has EBIT of $200,000 and a buyer is willing to pay 3x EBIT for a similar retail business which leases its operating facilities, the buyer will value it by adjusting EBIT for the cost the buyer would have to incur, if it were to lease comparable facilities, and adjusting the company’s valuation for the value of the property and building assets. If the buyer has to pay $20,000 a year for leasing similar property, and can sell the property and building for $600,000, the buyer might value this company at 3x adjusted EBIT, plus the value of the property and building.

3x ($200,000 – $20,000) = $540,000 + $600,000 = $1,140,000

[Click to continue reading]

What is CAPM? How do you calculate the return of a stock?

Nitin Garg628 Comments

Capital Asset Pricing Model (CAPM) is one of the models used to estimate the cost of equity. CAPM, developed by William Sharpe, the Nobel Laureate in Economics, defines a stock’s risk as its sensitivity to its market. In other words, when we invest funds, we expect a rate of return against the risk taken. CAPM helps us derive the investment risk and the return we can expect on our allocated fund. As an analyst, CAPM should be used to decide the price the investor should pay for a particular stock. If Stock A is riskier than Stock B, Stock A should be priced lower to compensate investors for the increased risk.

CAPM defined by the following formula, says that the expected rate of return on any security equals the sum of risk-free rate and the security’s Beta times the market premium risk

                                                          E(Rs) = Rf + Bs * [ E(Rm) – Rf ]
Where,

E(Rs) = Expected return of the security, s
Rf = Risk-free rate
Bs = Stock’s sensitivity (how the stock and the market move together)
E(Rm) = Expected return of the market

In CAPM, the Rf and the market risk premium, E(Rm) – Rf), remains common to all companies, but it is the Beta, Bs, that varies – Bs is the stock’s incremental risk. While it’s not absolutely clear, the CAPM says that the only reason an investor should gain more from Stock A compared to the Stock B is the increased risk taken on Stock A.

Few points noteworthy:

  • To estimate the risk-free rate, we use highly liquid long-term government bonds like 10-year zero coupon STRIPS, US Treasury bills, etc. as a proxy.
  • Beta: If a stock price exactly replicates the market, its Beta is 1. A stock with a beta of 1.2 means it’s theoretically 20% more volatile than the market.